Tax Consequences of Deferring or Restructuring Payments


During the current economic downturn arising from the COVID 19 pandemic, many businesses are struggling with payments to lenders, landlords and contractors.  This SGR Tax Blog posting addresses the tax consequences to each party when a payment is deferred or renegotiated.

While the tax consequences of such are frequently not foremost in the minds of debtors, they often drive decisions on the creditor side.  Accordingly, even for debtors an overview of these rules can help explain positions taken by creditors.

The tax rules on debt instruments (“DI’s”) are more complicated and we address them first.  Leases and other arrangements are often subject to separate rules and are covered later.

  1. Loans, Mortgages and Other Debt Instruments

Changes to the terms of a debt instrument can have a variety of tax consequences.  If the principal balance is reduced, then the debtor can often have cancelation of debt (“COD”) income.  More commonly, the parties to DI may wish to change other terms.  If the changes are treated as a “significant modification,” then the old DI is treated as if it is exchanged for the as-modified DI.  This is so even if the parties treat the changes as an amendment to an existing DI and contemplate that for state law purposes the original DI continues in existence.

Frequently, then, the goal is to ensure that the changes do not constitute a modification under the tax rules.  Even where this occurs, the next strategy is to ensure that the modifications are not treated as “significant.”  Finally, even if the changes trip the significant modification test, the tax consequences may not be material.  We address each of these in turn.

A. Deferrals that are not modifications.

After the recession stemming from the subprime mortgage crisis in 2007, the tax rules were adjusted to provide that certain types of deferrals are not modifications and thus can never be significant modifications.

The basis for this rule is that a creditor’s failure to enforce its rights under a DI is not a modification in certain circumstances.

Thus, a formal or informal agreement by a creditor to stay collection or temporarily waive an acceleration clause or similar default right (including such a waiver following the exercise of a right to demand payment in full) is not a modification unless and until the forbearance remains in effect for a period that exceeds two (2)  years.  In addition, the safe-harbor period is extended (1) during any period in which the parties conduct good faith negotiations, or (2) during which the issuer is in a title 11 or similar case.

In addition, any deferral pursuant to the original terms of the DI is not a modification.  The tax rules contain an example in which the debtor has an option under the DI to defer interest payments until maturity provided that the applicable interest rate increases 200 basis points.  The debtor’s utilization of that provision is pursuant to the terms of the DI and therefore is not a modification.

Finally, as described below, there is a safe-harbor for payment deferrals that do constitute a modification.  If the safe harbor is satisfied, the modification cannot be treated as significant and thus cannot trigger a deemed exchange.

B. Changes that are modifications but are not significant.

If a deferral or other change is a modification, there are a number of safe harbors that prevent it from being treated as significant.  The following table provides a general summary of these rules, but note that there are many exceptions and caveats that are omitted in the interest of brevity:

change in interest rate A change in interest rate is not treated as a significant modification unless the yield changes by the greater of (i) 0.25 percent points (i.e., 25 basis points) or (ii) 5% of the old DI’s yield.
change in timing of payments A change in the timing of payments under a DI is a significant modification if it results in a “material deferral of scheduled payments.”  Notwithstanding this, the deferral of payments within a defined safe-harbor period are not treated as significant.  The safe-harbor period begins on the original due date of the first scheduled payment that is deferred and extends for a period equal to the lesser of (i) five (5) years or (ii) 50% of the original term of the DI.
change in obligor or security With some exceptions, the change in the obligor on a DI is always a significant modification, unless the DI is a nonrecourse obligation.

The addition of a new obligor or deletion of an existing obligor is a significant modification if it results in a change in payment expectations.

A change in security (i.e., the release or enhancement of collateral) is a significant modification if it results in a change in payment expectations.

change in the nature of DI A change to the nature of a DI is often a significant modification.  Thus, a conversion of an instrument from debt to equity or from recourse to nonrecourse is generally a significant modification.  However, in testing this any deterioration in the financial condition of the debtor after the original issuance of the DI is ignored.  This means that the fact that a debtor poses a significant credit risk at the time of modification would generally not cause a DI to be re-classified as equity.
change in accounting or financial covenants modification that adds, deletes, or alters customary accounting or financial covenants is not a significant modification.

C. Consequences of a significant modification.

As noted, if the parties make a significant modification to a DI, then the old DI is treated for tax purposes as being exchanged for the as-modified DI.  Even if this occurs, it may have little in the way of material tax consequences.

Example 1:

Bank makes a loan to Newco.  Years later, but before the loan is due, Newco experiences financial problems arising from COVID 19.  Assume the loan balance is $1 million and is otherwise due in 2 years.  Newco negotiates with Bank and proposes to go from monthly level payments to a single balloon payment in 5 years.  In exchange for these changes, Newco also proposes to increase the interest rate on the loan from 5% to 10%.

If the Bank finds the proposal acceptable, are there any tax consequences?

These changes likely would be treated as a significant modification under the applicable tests.  Accordingly, Bank would be treated as exchanging the old loan for the as-modified loan.  If the Bank was the originally lender, it generally would have a tax basis approximately equal to the unpaid balance of the loan.  Moreover, the issue price of the new DI likely would also be equal to the unpaid balance of the loan.  Accordingly, the Bank would experience a taxable event, but the gain would be zero:

  $1,000,000 issue price of as-modified DI
-$1,000,000 Bank’s tax basis in old DI
 $0 taxable gain (loss)

From a practical perspective, this means that the tax consequences generally will not pose an obstacle.  If Newco’s proposal is otherwise acceptable to Bank then the fact that the changes constitute a significant modification should not pose a problem.

Example 2:

Same facts as Example 1, except that Bank becomes worried about Newco’s ability to pay and sells the Newco loan to Investor for $500,000 before Newco proposes a work out.  Upon learning of the assignment, Newco contacts Investor and proposes the same work out as described in Example 1.

If Investor otherwise finds the proposal acceptable, however, the tax consequences may pose a problem.

As noted, these changes likely would be treated as a significant modification under the applicable tests.  Accordingly, Investor would be treated as exchanging the old loan for the as-modified loan.  Unlike Bank in the previous example, however, Investor will have a tax basis of only $500,000 but the issue price of the new loan will likely be treated as $1 million.  Accordingly, Investor will have significant gain:

$1,000,000 issue price of as-modified DI
 -$500,000 Bank’s tax basis in old DI
  $500,000 taxable gain (loss)

Importantly, this is “phantom” gain.  That is, the income tax consequences are triggered today, while the cash is not received for five years.  Thus, under these facts the income tax consequences are likely to pose a barrier to the work out.  While there are techniques to mitigate or avoid these results, Newco needs to be mindful that any work out with a subsequent acquiror of a DI can present extra obstacles.

  1. Leases and Other Obligations

The foregoing discussion looked at work outs involving debt instruments.  Distressed businesses also often seek to restructure other legal arrangements, such as leases, employment agreements and other contracts.  While there are special rules for each of these types of arrangements, they are generally easier to modify without triggering tax consequences than debt instruments.

However, there is an important caveat.  In a lease or other contract, any amounts that have not been paid are treated as debts for tax purposes.  For example, assume a tenant owes $100 in back rent to a landlord and attempts to get the arrearage cancelled in exchange for better terms for the landlord going forward.  If the landlord agrees, the cancellation of the back rent may be treated as COD income to the tenant.  The tenant might be better off by proposing to pay the back rent in full, but reducing the rent in some fashion going forward.

Action Points:

  • Make sure any loan payment deferrals or waivers fit within special tax safe harbors.
  • For other modifications, determine if the creditor is the original lender or acquired the DI at a discount.
  • Original lenders generally will not have adverse tax consequences if they agree to significant modifications, but creditors who acquired debt at a discount may find the tax consequences of certain changes a high barrier.
  • For leases and other contracts, be wary of canceling arrearages. Consider solutions that provide for full payment of past due amounts, with reductions in future payments.
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